“Above all else, show the data.” – Edward Tufte
“Torture the data, and it will confess to anything.” – Ronald Coase
While a lot of folks are allowing their attention to be hacked by the latest tweet, squirrel or AI-vowel combo to float by – and the entire landscape begins to suffer from an increasing left-brain imbalance – let’s not forget the value of authorship. You know, the thing that reminds you that your “AI” is still just a bunch of nested if-then statements – and can’t possibly solve the puzzle you are about to solve for the distant foreseeable future. That kind of “AI” is a snob that can only function on data that is somehow cleaner than reality…
Turns out, there remains a ton of valuable data lying around – as I have been saying on our Feed lately – hiding in plain sight. And, it turns out, that that data has been disclosed in small, hard-to-reach, chunks precisely because it’s quite valuable once distilled properly, like a fine Kentucky bourbon. And, once distilled properly, authorship can be applied to coax that data to sing songs like Mercury or paint pictures like Dali. And, every once in a while, even the raw, seemingly innocuous data will cough up a pearl that need not be distilled at all.
In the chart below, Alphacution has built part of a storyboard around one such pearl: 2010 revenue of $888 million for Citadel Securities used to calculate that year’s broker-dealer SIPC assessment. Now, it’s not clear yet if this pearl is disclosed by error or by some force of serendipity. And, finding it doesn’t necessary mean that the fog is entirely cleared away; only that the fog is diminished enough for Alphacution’s contextual modeling assets to use it as crowbar to pry open another can of intelligence:
Here, we are leveraging some figures from our recent modeling of Citadel, namely the time series of total assets and member’s capital, which is further complicated by the fact Ken Griffin seems to have a fetish for spawning new legal entities to wrap around every function within his expanding empire. Note that we needed to add the new financing entity, Citadel Clearing, LLC (which was formerly housed within Citadel Securities, LLC prior to 2015), in order to complete the true trajectories of this business through to 2018.
Anyway, it’s all very wonky and nerdy. The point is that we can use the true trajectory of assets (2.6x growth from 2010 levels) and member’s capital (2.2x growth from 2010 levels) to at least throw a dart with a modicum of credibility greater than an outright finger-in-the-air swag to target a 2018 top line revenue range for Citadel Securities of $1.5 – $2 billion based on the 2010 revenue disclosure of $888 million and given the likely headwinds that have plagued even the strongest players in our structural alpha zone since 2010.
For more on this story, please continue here as excerpted from the upcoming case study, Deconstructing Citadel Securities – and download the executive summary, below:
The early highlights of this story are well established among students of the hedge fund and proprietary trading arenas – and given the extremes of financial and technological success that have taken root here, they are well known to the broader financial services industry, too. Certainly, recent tales of the founder’s real estate trophy-hunting exploits have helped to fuel the current potency of ongoing mystique and mythology surrounding the organization:
Founded in 1990 by 21-year old Harvard University student, Ken Griffin, and initially based on a convertible bond arbitrage strategy, Citadel (legally now known in the US as Citadel Enterprise Americas, LLC along with the vast and complex global lineage of predecessor and related affiliates) has consistently evolved in a manner that solidifies its reputation as one of the most legendary trading and asset management powerhouses of the modern era. For example, as of 2017, Citadel was ranked by Institutional Investor as the #3 most profitable hedge fund manager since launch, trailing only Ray Dalio’s Bridgewater Associates, LLC (#1) and George Soros’ eponymous Soros Fund Management, LLC (#2). Today, the alternative asset management side of the shop, Citadel Advisors, LLC, sits atop an estimated $30 billion in assets under management (AUM), putting it at #11 in a ranking of top hedge funds by AUM (trailing Seth Klarman’s highly-concentrated, long-only, debt-focused hedge fund management platform, Baupost Group, Inc., at #10), according to Q2-2018 data from Pensions and Investments.
Headquartered in Chicago, with operations spanning key global financial centers, Citadel’s portfolio of market strategies is rivaled by few, if any, others. And with limited exceptions (such as digital assets, to date), Citadel is active in most cash, derivative, listed and OTC markets for financial and commodity products around the world, typically on the cutting edge of the most automated and data-intensive methods possible. In other words, they trade just about everything that moves with significant, unrivaled quantitative prowess.
On this basis, and despite profound dominance in US listed equity markets, Alphacution has historically argued that there is actually no core strategy here. In fact, we believe that that Citadel’s “special sauce” – the blessing (and the curse) that Ken Griffin has bestowed upon and infused throughout the only place he has ever worked – is a maniacal sensitivity to data processing no matter the underlying product, asset class, region, or set of signal generation inputs. The application of intelligence in global markets based on unprecedented data management assets and human capital skills is at the heart of everything that Citadel pursues – and the results, including the expansive and expanding trophy case of its founder, speak volumes.
So, it is with this brief prelude of mostly retreaded highlights as backdrop that we embark upon our mission to tell a version of the Citadel story that has never been told before. Even better yet, there is no more quintessential accomplice to have on this mission than the subject of the story itself.
Assembling Data Exhaust
Alphacution’s version of the Citadel story is being underwritten by the substantial regulatory data exhaust from the underlying operating engines of Citadel itself. It turns out, if you know where to look, there is significant amounts of data – related to Citadel and many other of the most profitable, impactful and mythological entities in the financial universe – hiding in plain sight. All you need is the patience, tenacity, vision and experience to assemble that cache of freely-available data into a storyboard that is more easily consumable by a larger audience than the raw forms of that data initially allow.
This is precisely what Alphacution has done here. At the core of this story is a case study on Citadel Securities, LLC; the market making and proprietary trading business that, on the one hand, stands as a separate and distinct trading business from Citadel’s hedge fund operation and yet, on the other hand, Alphacution believes plays a critical and symbiotic role in the overall success of the broader Citadel trading and asset management empire.
We have observed similar patterns of “nested multi-temporal strategies” across separate and distinct legal entities on the sell-side, with the likes of UBS, Morgan Stanley, Goldman Sachs and others, and on the buy-side, with the likes of Jane Street, Wolverine, Susquehanna, Hudson River Trading and others – and further believe that Two Sigma’s late 2017 acquisition of Interactive Broker’s option market making operation, Timber Hill, was a bid to emulate this type of nested strategy architecture. Moreover, the idea of coordinating strategies by relative trading turnover frequencies (i.e. – temporal sequential) in order to optimize transaction costs, market impact slippage and margin efficiencies is not particularly new, as was exemplified by the Andy Sterge-led BNP CooperNeff quant operation of the late 1990’s. So, in short, we start this case study with Citadel Securities because the best version of the story cannot be told any other way.
Now, in order to best understand and appreciate the dynamics of Citadel – including its elaborate constellation of related legal entities – we recommend that you first consider a very wide-lens perspective of the market ecosystem; in a sense, to see it as one that behaves like a live organism. Of course, this non-linear and non-stationary – “living, breathing” – aspect of the global markets ecosystem has always been present. It’s just that today the data, technical leverage and experiential overlay has accumulated to the point that we can make a clear sketch of it. In time, Alphacution’s vision is to take advantage of improvements in each of these factors to evolve the initial sketch to the point of being a real-time and interactive “movie” of the macro-to-micro structure of the global markets universe.
Today, like the health of a coral reef, the size, quantity, diversity, and other key attributes of the players, products and strategies thriving and decaying within the financial ecosystem are all sources of data exhaust that can incrementally and collectively help us sketch the aforementioned picture with increasing precision and accuracy. And, though there are numerous, relatively generic versions of, say, long-short equity hedge funds or “smart beta” asset managers, there is only one critter in this ecosystem that is configured quite like Citadel. It’s the global markets’ incarnation of a Night Fury dragon. There is only one – and its ongoing success, given the winner-take-all dynamics of this tech-centric, digital era, may ultimately turn out to be a threat to many of the remaining players and the overall health of the ecosystem.
Here’s where our current sketch of the global financial ecosystem begins: From Alphacution’s initial buy-side study, “The Context Machine: Estimating Asset Manager Technology Spending” – and the post to our Feed that introduces that work, “What Does Citadel* Spend on Technology?” – we present our asset management ecosystem map which starts the process of segmenting market participants into three primary strategy zones based on coordinates established by measures of technical and human capital leverage.
In other words, trading and asset management firms are aligned on this map based on implied levels of workflow automation. In the version of the map, below, we showcase the structural alpha zone – with Alphacution’s rendering of all US listed market liquidity pools – to emphasize the hypothesis that some substantial yet finite portion of available alpha capacity is transactional in nature, and therefore, best discovered and captured in closest proximity to the sources of liquidity.
Exhibit 1: Asset Management Ecosystem Map – Focus on Structural Alpha Zone (v1.1)
Here’s the expanded takeaway from this map metaphor: Those firms that operate closest to the sources of listed liquidity tend to emit similar operational attributes. Among these are high technology spending, high workflow automation, and low headcount – which tips the hand that each is executing the most active trading strategies among the full spectrum of investable strategies. In short, strategy selection is correlated to these other factors. Moreover, to harvest the benefits of closest proximity to liquidity (i.e. – transaction cost and margin advantages, among others), each of these trading operations also tend to have similar disclosure requirements.
This is because US broker-dealers (who are governed by the SEC, FINRA and SIPC and are required to file a FOCUS report) that are also active enough to be accumulating positions (to the extent that they are required to file a 13F report with the SEC) tend to be among the largest market makers and proprietary trading firms who operate in the region of the ecosystem where the pressure to minimize trading costs – namely, transaction costs, market impact and margin efficiencies – is the highest. In short, these critters need to live in a climate where their specific brand of food, with specific nutritional content, can be found in abundance.
Based on the broader ecosystem map and the concepts behind the operational acclimations within specific zones on that map, Alphacution has developed a series of schematics that identifies the “Top 100 Players in US Listed Market Structure” – including US equity exchanges, sell-side liquidity venues (dark pools); independent, agency, and consortium dark pools; non-bank single dealer platforms (SDPs) and the Tier 1 buy-side and sell-side players that are the primary sponsors and market makers that interact with these sources of liquidity.
That research and modeling culminates to date in the illustration that can be found in Exhibit 2, below. It is here, given the proximity to and prowess around the sources of liquidity – and not necessarily with the impressive legacy of its flagship Kensington and Wellington hedge funds – that Citadel Securities (along with, in part, its dark liquidity platform, Citadel Connect; both highlighted in yellow below) has established and solidified the broader organization’s market leading position.
Exhibit 2: Top 100 Players in US Listed Market Structure Schematic (v1.0)
This work has also led to a corollary hypothesis that the capacity of alpha is finite, albeit elastic, as well. Alphacution’s focus on leading market makers and proprietary trading firms – with Citadel heading the list – is born out of this central idea:
If the capacity of alpha is finite, and a subset of leading market makers and proprietary trading firms (and select quantitative hedge funds) are capturing more of that finite alpha by deploying increasingly automated and sophisticated trading engines, then what happens to the declining residual capacity of alpha in the neighboring active and passive management zones?
Alphacution expects that many market actors and their stakeholders are going to be interested in the answers to these and similar questions because 1) it has never been more obvious to ask them until now, 2) the success, if not the survival, of their businesses may depend on finding answers to them, and 3) there is no other research platform developing a framework to offer credible answers to questions like these. The following illustration is the next in the series of visual metaphors for the data-driven model that Alphacution is developing to quantify these phenomena.
Exhibit 3: Asset Management Ecosystem Map – Expanding Schematic into Active and Passive Management Zones
With these concepts and Alphacution’s proprietary framework as backdrop, the following select findings represent our interpretation of Citadel Securities’ trading and, by implication, business strategies…
The rest is coming soon…
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